Remember, You Are Part of the Market

I’m a sci-fi nut… and proud of it!

I’ve attended multiple Star Trek conventions, and I’m not ashamed to admit that I routinely use Spock’s neck pinch to silence my children when they become insolent. Frankly, it works, and who am I to argue with Vulcan logic?

At any rate, I spent the long weekend binge-watching the first season of Travelers, which you can think of as a darker, dystopian version of the 1980s and 90s sci-fi drama Quantum Leap.

In Travelers, what is left of the human race in a post-apocalyptic future travels through time by transmitting their consciousnesses into the bodies of a people living in today’s world. They then use their knowledge of the future to shape history and try to prevent the human race from self-destructing.

Naturally, saving the world requires cash. But being from the future, that’s not a problem. The travelers have knowledge of every recorded horse race in history and can raise cash at will by betting on the horses they know will win.

At least it starts out that way.

The longer the travelers live in the present, the more they alter the timeline. The changes they make – preventing a war here, stopping a disease outbreak there – have unintended and impossible-to-calculate consequences. And suddenly, their “can’t lose” horse picks start losing.

Financial markets work the same way.

Imagine that you invent a time machine today and that you travel back to the decade of your choice. You use your knowledge of market history to bet on the winners… and to avoid or even short the losers. And you can time your purchases to the day.

You’d make a killing… for a while. You’d likely become the richest man in the world within a few short years. But at some point, your exploits would become so legendary that every Tom, Dick and Harry would copy you. Your trading would become a self-fulfilling prophecy, and stocks you bought would soar because you bought them, and stocks you sold would collapse because you sold them.

Eventually, your trading activity would affect the flow of capital to the point that you would change history… and then your knowledge of the future would be all but useless, as that future would no longer exist.

Now, don’t get me wrong. I’d still love to give it a try! But alas, I do not have a time machine at my disposal.

The thing is, you can see the same principles at work in the market even without one.

Warren Buffett’s returnrns today are respectable, but they are a fraction of the returnrns he generated back in the 1950s and 60s. Back then, Buffett managed a couple million dollars and was capable of regularly generating 30% to 50% annual returnrns.

But today, his holding company Berkshire Hathaway is worth half a trillion dollars.  Decades ago, Buffett could get in and out of a stock without moving its price. Today, at Buffett’s size, he can’t take a meaningfully large position in a company without instantly becoming one of its largest shareholders.

Plus, given the scrutiny with which Buffett is watched, millions of investors immediately pile into a stock as soon as they know Buffett owns it. Buffett isn’t an impartial observer. He moves the market.

Neither you nor I are time travelers, nor are we running hundreds of billions of dollars in capital like Mr. Buffett. But it’s easier than you might think to fall into the same traps.

Here are a few suggestions on how to avoid them:

To start, be wary of smaller companies or ETFs with limited trading volume. With a thinly-traded stock, it doesn’t take much to move the market. Even a $10,000 position can be hard to unwind in a hurry if you’re trading a penny stock.

Along the same lines, be wary of leverage. It really doesn’t matter how responsible you think you’re being. When leverage is involved, your portfolio is subject to getting wiped out during sudden bouts of volatility.

This is effectively what killed Long-Term Capital Management back in 1998. They effectively got the mother of all margin calls on what would have been, at lower levels of leverage, a sensible and conservative portfolio. It’s also what caused many of the short-volatility funds to blow up earlier this month. Any otherwise safe strategy can be made risky by piling on leverage.

And finally, always remember that, as a trader or investor, you are part of the market that you’re trying to exploit. This is what George Soros called “reflexivity.” Our view of reality (that a stock will go up in value) actually causes that reality to happen.

In other words, a stock rises in value because enough people believed it would rise in value, thus buying it and pushing the price up. True value is an abstract concept and one that doesn’t actually exist in the financial world.

Also, to any of you that might be diligently working on a time machine, please do me one favor. If you’re successfully able to go back in time, please ensure that my beloved TCU Hornrned Frogs never sign Kenny Hill to be quarterback.

While I understand that tampering with the timeline puts the space-time continuum at risk, you’d be sparing me the pain of watching him lead the Big 12 in interceptions, and that’s clearly worth the risk.

Charles Sizemore

Portfolio Manager, Boom & Bust

Charles Sizemore

Charles specializes in finding value opportunities and income plays outside of the mainstream stock market.